Introduction

Interest rates can have both positive and negative effects on the U.S. Markets. The correlation of two will tell us how and in what ways the markets can be effected by any move up or down. To full understand them we will explore how interest rates can effect the U.S. Economy and the effects of these changes on the U.S. Stock Market as well as the bond market. In this article we will answer the above effects to give you an overall big picture view of how interest rates and the U.S. Markets are intertwined.

How Interest Rates Effect the U.S Economy

The economy is constantly adjusting to changes that come its way. When the Federal Reserve (the Fed) changes the amount that banks borrow money this has a ripple effect across the entire economy. However, it is important to understand that there is generally a 12 month lag in the economy. Meaning, that it can take up to that long for these effects to be felt. Below we will examine how interest rates can have an effect on the economy in addition to how they can effect both inflation and recessions.

Interest Rates

Interest rates are the amount that is charged to borrow money. It is calculated on a percentage basis (such as 1% etc). They allow you to spend money immediately compared with trying to save the money to make a purchase. The interest is the amount of money that lenders makes by loaning you the money. With every loan there is a possibility that you will not pay the money back. The lower the interest rate the easier it is for people to borrow money to make big purchases such as buying a house or car. This creates a ripple effect where consumers will pay less in interest which will give them more money to spend. Second, businesses and farmers can benefit from lower interest rates because this allows them to go out and make equipment purchases due to the low cost of borrowing. This creates a situation where output and productivity increase. Conversely, higher interest rates means that consumers don’t feel as prosperous as they once were and cut back on spending. While, banks raise lending standards becoming less likely to lend money and businesses cut back on spending for new equipment, thus, slowing or reducing the number of employees they have.

How do interest rates effect inflation and recessions?

When ever interest rates are rising or falling you commonly hear about the Federal Funds Rate. This rate is the rate that banks use to loan each other money. It can change daily and is used an indicator to show if rates are rising or declining. When this rate rises or declines it will affect all other loan rates. These changes can have an effect on both inflation and recessions. Inflation is when you have a rise in the price of goods or services over a certain length of time. It is the result of a strong and healthy economy. However, if inflation is left unchecked it can mean that people are spending more money to purchase goods or services. The Fed will watch inflation indicators such as the Consumer Price Index (CPI) and Producer Price Index (PPI) when these indicators start to rise more than two to three percent a year, they will raise the Federal Funds Rate to keep the rising prices under control. Meaning, higher interest rates mean higher borrowing costs which eventually will lead people to spend less. Causing the demand for these goods and services to drop, which will cause inflation to fall. A good example of this occurred in the 1981 to 1982 time period. Inflation was at 14% a year and the fed raised interest rates to 20%. This caused a severe recession but it did put an end to the spiraling inflation that the country was seeing. Conversely, falling interest rates can cause recessions to end. What happens is when the Fed lowers the Federal Funds Rate this causes lending standards to become easier, allowing consumers to have more money and feel better about their situation. They will then go out make big ticket item purchases and have more money to purchase other items as well. Also, businesses and farmers will be able to make equipment purchases and refinance borrowing costs at lower rates to expand. A good example of this occurred in 2001 to 2002 when the Fed cut the Federal Funds Rate to 1.25%. This caused the economy to recover in 2003. By raising and lowering the Fed Federal Funds Rate the Fed can prevent runaway inflation and lessen the severity of recessions.

Effect of interest rates on the U.S. Markets

Interest rates can have an effect on both the U.S. stock market and bond market. The effects on the stock market are many investors have a wide variety of investment options when you compare the average dividend yield on a blue chip stock to a certificate of deposit (CD) or U.S. Treasury if the rate is higher on the blue chip stock then many investors will take more risk and buy the blue chip stock that is paying the higher dividend. Conversely, when the rate on safe investments is higher such as CD’s or Treasuries compared to blue chip stocks many will go with the safe investment in this case. The amount where the Federal Funds rate is currently sitting will determine how investors will invest their money since both CD’s and treasury rates are effected them. Second, rising or falling interest rates will have an effect on consumer and business psychology. When interest rates are rising at some point both businesses and consumers will cut back on spending. This will cause earnings to fall and stock prices to drop. On the other hand, when interest rates have fallen significantly this will cause consumers and businesses to increase spending causing stock prices to rise.

Interests Rates also have an effect on the bond prices. There is an inverse relationship between bond prices and interest rates. Meaning that as interest rates rise bond prices fall and as interest rates fall bond prices rise. The longer the maturity of the bond the more it will fluctuate in relation to interest rates. As interest rates move up the cost of borrowing becomes more expensive. One way that governments, businesses and other organizations raise money is through the sale of bonds. This means that demand for lower paying or yielding bonds will drop causing the price to drop. As interest rates fall this means that it easier to borrow money and many companies will issue new bonds or debt to finance expansion. This will cause the demand for higher yielding bonds to increase forcing bond prices higher. Some will even refinance or what is known as call the existing bonds so they can lock in a lower interest rate.

Conclusion

Interest rates have an effect on the economy as well as the U.S. markets. Generally any move up or down will take at least 12 months for its effects to be felt. The two forces that Fed targets by the rises or decreases in the Federal Funds Rates are inflation and recessions. By targeting both factors with this tool they can keep the economy in balance long term. These moves also have an effect on what choices investors make in the stock market and earnings. They will also determine if stock prices rise or fall. Interest rates also have an inverse relationship on bond prices meaning that as rates are rising bond prices will fall and when rates are declining bond prices will rise. By understanding this relationship between interest rates and the U.S. markets will allow us to understand what the overall big picture is as well as what the effects are.

Tags: amount of money, big picture, consumers, economy, banks, lenders, correlation, interest rate, interest rates, buying a house, federal reserve, recessions, inflation, ripple effect, farmers, bond market, percentage basis